With US corporate profits at their strongest since the 1960s, representing almost 9% of GDP, the US...
With US corporate profits at their strongest since the 1960s, representing almost 9% of GDP, the US equity market has rallied in recent months and is now back at levels last seen in mid-2001. Christmas has surely come early for many American shareholders. Yet we believe that investors should be cautious about increasing exposure to US equities from here.
Higher raw material costs accelerating wage growth and rising interest-rates are the most immediate headwinds. We also expect the rate of expansion to slow because of below-average levels of capacity utilisation, even though profits margins still have some room to increase. Capital spending is also likely to pick up, having fallen to a post-World War II low.
Although investment may prove profitable over time, shareholders are likely to be sceptical in the short term as they see companies spending money rather than returning it to them.
Though the rate of earnings growth is now slowing the market seems to have priced it in. Indeed next year's consensus earnings growth expectations of 8% may turn out to be too conservative, in spite of the cost headwinds.
The first half of the year will more than likely show faster growth as corporations continue to benefit from economic momentum globally.
What is more likely to be a ceiling for the market is valuation. The S&P 500 Index now trades at a price/earnings ratio of 17.0x these 2005 projections, above the long-term average of 15.0x, in spite of higher than average margins. We question whether this multiple is sustainable, particularly in a rising inflation environment.
We would prefer to gain exposure to US equities at a discount rather than a premium to other markets, but this is not possible today.
Our preference remains for Asian markets where prospective earnings multiples of 12x to 13x are low relative to historic levels. We also believe that these markets offer greater prospects for a positive earnings surprise than US equities.
Of course even in this difficult environment certain areas of the US market are likely to perform well.
We favour industrial, energy and material companies, where a lack of investment over the last decade has led to supply shortages and rising prices. Tyco, Danaher, Caterpillar, Transocean and Alcan are examples of firms that should perform well on this basis. They should also benefit from our anticipated rebound in capital spending.
On the other hand, we expect weakness in consumer sectors next year, where growth and margin expectations look lofty at a time when the US consumer is likely to spend at a slower pace.
They have spent more than 100% of their disposable income over the last three years, well above the 45-year average of 80%, and we expect something of an adjustment. Both consumer discretionary and staples sectors are likely to prove disappointing in this environment.
Earnings look set to grow next year.
US equities cheapest they have been since 1997.
Lack of historic investment implies infrastructure spending.
US equities expensive relative to other markets.
Short-term interest rates to continue to rise.
Consumer-oriented sectors remain weak.